Section 327(a) is All You Need: McDermott International Court Rejects Retention under Section 363(b) and the J. Alix Protocol

by Nicole Leonard and Jeffrey Bernstein

This article is  reprinted with the permission of the American Bankruptcy Institute. It originally appeared in Volume 18, Number 3 of the ABI Ethics & Professional Compensation Committee Newsletter, September 2020.

The McDermott International bankruptcy plan had already been confirmed by the time the hearing was held on the retention applications described herein.[1] The Honorable David R. Jones of the United States Bankruptcy Court for the Southern District of Texas (the “Court”) acknowledged that the success of the bankruptcy was related “in no small part” to the efforts and talent of the Debtors’ chief transformation officer (the “CTO”) and his team.[2] However, despite the CTO’s success, the Court was not content to approve his firms’ retention applications under Section 363(b) when that section of the Bankruptcy Code lacked the safeguards and transparency intended for the debtors’ professionals under Section 327(a). The resulting opinion is an entreaty by the Court to get back to basics and allow the (generally) elegant checks and balances of the Bankruptcy Code to function as they were intended.

The Court was faced with two applications for retention of the Debtors’ professionals: one for AlixPartners as financial advisor under Section 327(a) and the other for AlixPartners’ affiliate AP Services under Sections 105 and 363(b).[3] The Debtors’ pre-petition CTO, Mr. John Castellano, was to be designated as post-petition CTO pursuant to a pre-petition agreement. To avoid any issues regarding Mr. Castellano’s disinterest, or lack thereof, the application for AP Services was brought under Section 363(b).

The United States Trustee did not object to the 363(b) application. But, because the U.S. Trustee viewed Mr. Castellano as both an officer of the Debtors and an insider, and therefore not disinterested, he imputed Mr. Castellano’s lack of disinterest to the firms and argued that AlixPartners and AP Services were statutorily barred from retention under Section 327(a).[4] The U.S. Trustee asserted that both applications should be brought under Section 363(b) pursuant to the J. Alix Protocol (the “Alix Protocol.”)[5]

The Court disagreed but approved both applications under Section 327(a). The Court noted that the pre-petition employment of AlixPartners and AP Services did not preclude post-petition retention of those firms and further questioned whether a lack of disinterest would be imputed to AlixPartners and AP Services even if Mr. Castellano was, arguendo, not disinterested (and the Court made no determination that he was not).

The practices of filing of retention applications under Section 363(b) and the Alix Protocol were established in response to objections from the United States Trustee Program to retention under Section 327(a) of chief restructuring officers (“CROs”) in bankruptcy cases when such individuals had previously served as CROs or provided other crisis management services prior to the bankruptcy. The crux of the U.S. Trustee objection is based on an assumption that the individual acting as pre-petition CRO lacks the disinterestedness required for retention under Section 327(a). This lack of disinterest is then “per se imputed to the CRO’s firm.”[6]

In order to surmount this obstacle, retention applications have been brought under Section 363(b). Although Section 363(b) does not specifically address employment, it allows the Trustee/ Debtor to use, sell, or lease, property of the estate outside the ordinary course of business and, importantly, there is no requirement for disinterest. Thus, it has been a useful, if knotty, way to work around the requirements of Section 327(a). The Alix Protocol attempts to replicate the safeguards of Section 327(a) through a series of disclosures and reporting requirements aimed at promoting transparency in the absence of the oversight built into Section 327.[7]

But the Court observed that the Alix Protocol was being honored more often in the breach. The Court found that “[w]hile innovative at its inception, the Alix Protocol has become a tool to avoid transparency and create inequity,” noting that applicants selectively follow its procedures.[8] The Court noted that there seemed to be an ever-growing list of activities of professionals falling under the rubric of the Section 363 application. The Court found that this resulted in a retention process lacking the transparency and oversight mandated by Section 327. As examples, the Court related that under the Alix Protocol fee applications are not required, “advisory services are inappropriately categorized as ‘back office’ support services” and “[s]uccess fees are mentioned only in a back-page disclosure.”[9]

The Court revisited the core assumption that necessitated the Alix Protocol in the first instance – the disinterestedness of one member of a firm as a per se disqualification of the firm. Citing multiple other courts, Judge Jones found there was no per se rule under the plain language of the Bankruptcy Code. The Court refused to infer something that was not specifically stated in the statute. Recognizing that courts should assume Congress says what it means and means what it says, the Court found the Bankruptcy Code silent on whether the lack of disinterest of one member of a firm should be imputed to the firm. In contrast, the Court noted Fed. R. Bankr. P. 5002 was drafted to specifically prohibit the employment of a firm when any of its members are related to the bankruptcy judge.

The Court summarized the goals of Section 327(a) as ensuring the impartiality of professionals and providing court oversight over the reasonableness of compensation. The Court determined “[t]hese goals are best achieved through the transparent process of § 327(a)” on a case by case basis that is open to the public. Through this approach “[a]ll relevant code sections work in harmony to promote efficiency without the need for artificial constructs to achieve a specific result.”[10] Judge Jones stated his expectation that in the Southern District of Texas, future professional retention applications would be brought under Section 327(a).

While this opinion may not be the last word on the topic and the thorny issues that can arise when a debtor retains crisis management professionals, it is a worthwhile exercise to re-evaluate whether retrofitting one section of the Bankruptcy Code and setting up a protocol outside the Code — however well intended — strays too far from the essential transparency and checks and balances at the foundation of the Bankruptcy Code.

 


[1] In re McDermott International, Inc., 614 BR 244 (Bankr. S.D. Tex. 2020).

[2] Id. at 248.

[3] The case was filed on January 21, 2020 and the original application to retain AP Services was filed on February 19, 2020. The Court identified concerns with the application and on March 11, 2020, the Debtors filed a revised retention application for AP Services and a retention application for AlixPartners. Id. at 247.

[4] The Court noted that Mr. Castellano was never employed by the Debtors and the Court took no position as to whether an outside CTO who was not employed by the Debtors could be considered an “insider” pursuant to 11 U.S.C. §101(14)(b). Id. at 254, FN.3.

[5] The Acting United States Trustee for Region 7 pointed out in a Statement filed with the Court [Case No. 20-30336, Doc. 835] that the restructuring industry emerged after Section 327 was enacted as part of the Bankruptcy Code in 1978.

[6] Id. at 250.

[7] The Court noted that the Alix Protocol has been criticized by some courts, endorsed by others and has even been contained in Volume 3 of the United States Trustee Program Policy and Practices Manual. Id. at 250.

[8] In re McDermott Int’l, Inc., 614 B.R. at 252.

[9] Id. at 253.

[10] Id. at 255.